Our Economic Value model and Monte Carlo simulation suggests that ZAGG's share price has significant upside (Figure 1.1) from $10.58 as of May 10, 2012.
Our Monte Carlo simulation provides a range of 1,000 scenarios to determine the probability associated with making a minimum return of 20%, as well as the probability of taking a loss through either a short or long position.
For each scenario, a random value is generated for the unknown inputs in our discounted Economic Value model. These random values are based on reasonable ranges derived from 10-year historical distributions of company and peer data. While point estimates are often "precisely wrong," range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value (also known as Economic Profit, Economic Value Added, or EVA) calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.
Our estimate calculates a probability distribution of "fair value" as shown in Figure 1.2.
For ZAGG, the probabilities associated with making a 20% return or higher are as follows (Table 1.1):
- Long: 80% chance.
- Short: 1% chance.
The probabilities associated with losing under the following scenarios are as follows :
- Long: 6% chance.
- Short: 94% chance.
Summary statistics (Table 1.2) show an expected value of $15-16 based on the median and mean.
ZAGG's Ranking in Value Creation and Economic Value
To further validate and provide context to the reasonableness of our analysis, we compare ZAGG's operating performance with other companies. Amazingly this small company dominates when it comes to delivering long-term value to shareholders (Table 1.3), as measured on a size adjusted basis through Market Value Added (MVA) divided by Capital. MVA is the Market Value (Debt plus Market Value of Equity) less the book Capital employed in the business. MVA represents the accumulated value created over the life of a business or NPV, as well as shareholders' expectations of the future stream of Economic Value. Impressively, ZAGG is ranks in the top 5, generating $4.69 for every dollar invested of Capital.
The company's Economic Value/Capital, which is equal to the Return on Capital less their Cost of Capital (Spread) is ranked in 1st place amongst some of the best companies in the world (BIDU, AAPL, MSFT, GOOG, NFLX, ORCL, QCOM, DELL, INTC, RIMM, CSCO, WMT, BBY, AMZN, MMI, IBM, VZ, HPQ, CELL, BRCM, T, RSH, AMD, EA, NOKIA).
The key drivers (Table 1.4) of ZAGG's Economic Value performance stem from its ability to grow revenue, while generating significant returns on capital.
Reasonableness of our Valuation and Assumptions
The range from our Monte Carlo simulation is consistent with analyst estimates and the dispersion is overall more conservative than other valuation multiples (Figure 1.3), suggesting that overall our estimate of value is reasonable.
However, when we compare our assumptions of revenue growth and spreads (Return on Capital minus the Cost of Capital) to historical company and peer performance, our estimates are at best, conservative and at worst, reasonable. The ranges (Table 1.5) of revenue growth represent our 90% confidence interval. Forecast is substantially less than historical performance.
Historically (Figure 1.4) ZAGG has consistently been best in class relative to the universe of companies listed in Table 1.3, since 2008 (solid black line).
However, forecast (Figure 1.5) shows that our ranges are at the bottom of ZAGG's historical 90% Confidence Interval and descends within the interquartile range of the selected universe despite its strong relative performance.
The distribution of revenue growth in our Monte Carlo simulation (black solid line) overlaid against the distribution of the Universe's weighted average (dark blue dotted line), Apple (light blue dotted line), and the company's historical performance (orange dotted line), shows how our overall revenue growth estimates compare to different benchmarks (Figure 1.6).
Again our estimates of spreads exhibit the same reasonable characteristics as our revenue growth assumptions (Table 1.6, Figure 1.7, Figure 1.8, and Figure 1.9)
Conclusion - the Short Squeeze
Given ZAGG's strong fundamentals and what we think are conservative/reasonable estimates of the "fair value", the share price will eventually reflect the economics of this business. In fact, approximately 2 weeks ago the price seemed to be tracking towards our estimates of fair value, and apart from something catastrophic like accounting fraud, we expected it to continue on its path to reaching its fair value. Needless to say, within the last week, unsubstantiated claims questioning the validity of the company's accounting practices have since driven the stock price down. The article succinctly and persuasively negates the claims of accounting fraud. Coincidentally, as of May 10, 2012, the short interest as percentage of shares outstanding was 30.8%, and as a percentage of the float was 41.4% (source: Capital IQ).
Ironically, the events of the last couple of weeks may in fact work to the advantage of shareholders. It is our view that, in the long-term, the economics of a business will be reflected in the share price of a company. However, in the short-term there are gaps between value and price, and as the gap persists the pressure for the price to reflect the value can make for violent swings back to its fair value. As a result, given the amount of short interest coupled with the disparity between the current share price and its value, there is a good chance (94% to be exact) that sellers may be caught scrambling to cover their shorts due to margin calls. Given the amount of short interest this could take up to 7.8 days to cover (Source: Capital IQ). If this happens, the share price could ascend quite quickly. If such things as naked shorts exist then the ascent of this stock might be quite a bit higher, further squeezing short sellers as they desperately attempt to buy back shares.